It looks like someone linked you here to our printer friendly page.
Please make sure you go Back to Safehaven.com
for more great articles just like this one!

Dropping the Anchor

By: Michael Ashton | Thursday, January 24, 2013

The S&P managed to hit the seemingly-important 1,500 level today, before
fading to close unchanged. The market took heart early from the print of Initial
Claims at 330k. This is of course good news, although some blame may be due
to the holiday-shortened week (the BLS had to estimate claims for some states,
including California, which were unable to submit their figures in time) and
the still-volatile seasonal pattern. Traditionally, this is the week I start
paying attention to 'Claims, but each subsequent number matters more than
the last. I'd love to hear that the post-holiday layoffs weren't as
significant as they usually are, implying that more 'seasonal' workers are
being retained. I'm skeptical of it, though, until we see a few more weeks
of such evidence or confirmation in the survey numbers.

This is a good time to remember that economic data aren't "right" or "wrong";
they are experiments, like taking the heights of five random motorists and
trying to guess the average height of the people who drive on a particular
freeway. We never know the true underlying state of the economy, or the true
underlying trend rate of any particular economic datum. We come into an economic
release with a null hypothesis, and that hypothesis may either be rejected
or not rejected (economic data can never really confirm your hypothesis,
but they can support your hypothesis). It is for this reason that I
ignore the first few Initial Claims figures of the new year. The error bars
on them are so wide that it is almost impossible to reject any halfway-rational
null hypothesis. Once we have seen a couple more Claims figures in this range,
or gotten support for the notion of an improving job market from Consumer
Confidence figures (for example), it will be easier to reject the null hypothesis
that the economy is still bumping along in a nearly-jobless recovery.

Also today, the TIPS auction produced strong results despite the fact that
the market never priced in a 'concession' for the size. At 1:00ET, the bid
in the market was -0.62%, but the U.S. Treasury sold $15bln at a lower yield
(higher price) of -0.63%. Moving $15bln in size without hitting the bid is
a fair sign of hunger in the inflation market.

And why shouldn't there be hunger? If you think the economy is heating up,
you can't really short bonds unless you want to sell them and hope the Fed
is just about done buying. But the Fisher equation says:

(1+n)=(1+r)(1+i)(1+p), which we usually simplify
to say

Nominal rates = real rates + expected inflation

If the Fed is holding nominal rates constant, and investors are expecting
inflation to rise as growth heats up (note: I am not changing my view that
these are unrelated...I'm merely observing how investors behave in the market),
then TIPS ought to stay comparatively well-bid because investors will buy
breakevens as the bearish trade, rather than selling Treasuries in a Quixotic
attempt to outlast the Fed. I think breakevens and inflation swaps, which
remain near the highest levels since 2006 (in the 10-year sector) and near
the highest levels since there have been TIPS, are going to remain pretty
well bid.

The last data of the week are the New Home Sales (Consensus: 385k from 377k)
from December. The forecast is for the highest level of sales in several years,
and the biggest hurdle seems to be that inventories of homes remain very low.

One quick observation about home prices and "inflation expectations" that
is interesting. Pollster
Rasmussen reported today that 29% of Americans expect their home's value
to rise over the next year. While this is close to the highest levels the
survey has recorded (it was only started in April 2010), it is strikingly
low considering that both new and existing home sales prices are up at a double-digit
pace over the last year, and even the slower-moving Case-Shiller index has
home prices up at over twice the rate of core inflation (4.31% as of October,
the last available data, with next week's release expected to be 5.6%). The
point simply being this: the Federal Reserve relies mightily on the assumption
that inflation cannot really get started when inflation expectations are well-anchored.
But nowhere are inflation expectations better anchored, probably, than in
home prices - and yet, home prices are rising at something not far away from
the peak rates of a couple of years ago.

That's something to think about. Maybe it's time that the Fed dropped the
whole notion of anchored inflation expectations, which no one has ever demonstrated
since there are no good measures of consumer inflation expectations. The idea
of an inflation-expectations anchor was developed to explain why inflation
did not accelerate in the 1990s even while the economy did, causing previously-estimated
models to breakdown. There are other explanations that don't require positing
an anchor that cannot be measured (for example, the private/public debt ratio
plays an important role in my company's models), but the imaginations of the
academic community became...well...anchored to the idea. It's time to drop
that anchor...at least until we develop a way to measure those expectations,
and then to test the idea.

Michael Ashton is Managing Principal at Enduring
Investments LLC, a specialty consulting and investment management boutique
that offers focused inflation-market expertise. He may be contacted through
that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist,
and salesman during a 20-year Wall Street career that included tours of duty
at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation
derivatives markets and is widely viewed as a premier subject matter expert
on inflation products and inflation trading. While at Barclays, he traded
the first interbank U.S. CPI swaps. He was primarily responsible for the creation
of the CPI Futures contract that the Chicago Mercantile Exchange listed in
February 2004 and was the lead market maker for that contract. Mr. Ashton
has written extensively about the use of inflation-indexed products for hedging
real exposures, including papers and book chapters on "Inflation and Commodities," "The
Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven
Investment For Individuals." He frequently speaks in front of professional
and retail audiences, both large and small. He runs the Inflation-Indexed
Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes
for client distribution and more recently for wider public dissemination.
Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University
in 1990 and was awarded his CFA charter in 2001.